Europeans must face up to prospect of massive debt restructuring

Europe’s bourses have not done as well as others from renewed investor
appetite for equities, but even the depression-hit eurozone periphery has
seen big gains in share prices since the sovereign debt crisis began to
abate last summer.

For Europe, the banking crisis is a mere symptom of an underlying illnesPhoto: Reuters

Does this mean that pole-axed though some of these economies remain, things are about to change for the better?

Sorry to be a wet blanket, but regrettably not, and for this reason. The roots of Europe’s problems lie not in the credit crunch of 2008-9 – for Europe, the banking crisis is a mere symptom of an underlying illness – but as far back as 1995, when preparations for the euro caused interest rate convergence across what had previously been structurally very different economies.

This in turn created a credit bubble in the periphery; in some countries it was more a private sector phenomenon, in others a public sector one, and in at least two countries it was both. In any case, wages and prices in the periphery began to diverge from the core. There was stagnation in Germany and strongly rising prices in the periphery, making the periphery progressively less competitive. This misalignment in prices led to a rising trade surplus in the core, but ballooning deficits in the periphery.

And that’s what the eurozone maelstrom is about – it is a classic, uncorrected balance of payments crisis. Normally, such crises are stemmed through the natural market mechanism of exchange rate movements, which both restore price competitiveness and, through devaluation, haircut the debt overhang in deficit nations.

There is no such automatic stabilisation mechanism in monetary union. The result is a debt standoff, with creditor nations demanding their pound of flesh from debtors forced into self-defeating penury in an attempt to provide it.

To regain competitiveness, debtor nations have no option but to counter the misalignment through cuts in nominal wages and asset prices, an exceptionally painful process socially and politically. Democracies struggle to achieve internal devaluations of this sort. So is there any sign of progress?

Apologists for the euro draw encouragement from two sets of data. One is that previously yawning current account deficits are indeed narrowing sharply. Ireland is already back in current account surplus. According to the IMF’s World Economic Outlook, Spain (with an astonishing 10pc deficit at the height of the credit bubble) and Italy will also be in surplus by the end of this year. Even bottom of the class Greece, with a current account deficit of 15pc in 2007, struggles back into surplus next year on these forecasts.

On this measure, then, Berlin is succeeding in transforming Europe into a regimented series of German look-a-likes.

The same is true of unit labour costs, the second yardstick that eurozone policymakers like to judge their success by. These have begun to converge with the German core since the crisis began, so you might argue that the price correction is well under way.

Yet look beneath the bonnet, and neither of these phenomenon can be counted a success. True enough, some deficit nations are doing well on exports – certainly better than Britain, with its apparent “advantage” of currency devaluation. But in most cases exports still remain below pre-crisis levels.

No, the primary reason that current account deficits are closing is that internal demand has collapsed, and with it, consumption of imported goods and services. Much the same dynamic underlies the apparent success with unit labour costs. What improvement there has been – actually in Italy it has been pretty marginal – is driven primarily by rising unemployment, or fewer workers producing the same amount of goods and services.

What’s more, the primary focus of wage adjustment has been in the public sector, because that’s where it can most easily be achieved. Nominal wage reductions in the traded goods and services sectors have been far less marked. Many Spanish exporters, for instance, are already relatively competitive, so why should their workers accept less? We’ve also seen the development of a highly bifurcated labour market, with employers offering temporary, low-paid work to new workers while retaining strong protection for existing permanent jobs. Labour market reform has been patchy and inadequate.

Internal devaluation of the sort demanded by membership of the euro in any case comes at a high fiscal cost. By cutting wages, the fiscal position is made worse, both because tax revenues are reduced and because it shrinks the size of the economy, thereby increasing the relative size of the existing debt burden. Internal devaluation makes the task of achieving debt sustainability virtually impossible, unless accompanied by massive debt restructuring.

Raising taxes to plug the deficit, meanwhile, only worsens the competitiveness problem further. If, on the other hand, the fiscal adjustment was halted, it would slow the return to competitiveness. There is an element of Catch 22 in the periphery’s efforts to get out of the mess it is in.

The task could plainly be eased if Germany were to accept higher inflation, but German industry is never going to make itself less competitive for the purpose of helping a southern Europe which today accounts for just 10pc of its exports. German exporters have seen growing success in emerging markets even as their once buoyant European markets shrink.

Nor even if Germans were prepared to accept higher inflation would they be likely to agree the European Central Bank actions necessary to bring it about. ECB plans to ease credit conditions in the periphery by buying asset backed securities were last weekend condemned by Wolfgang Schaeuble, the German finance minister, as “covert state financing”.

He also seems fast to be backtracking on banking union. Joint resolution would necessitate treaty change, he said, a lengthy process requiring referendums in many eurozone member states. Nations such as Spain, still hoping the creation of a banking union will solve their banking crises for them, have got a very long wait ahead of them.

To work, internal devaluation has to be accompanied by debt restructuring. Creditors have to accept that their assets are worth less, in the same way as workers have to accept a pay cut. Yet there remains little recognition of this truism on the Continent – as I discovered in a volley of nationalistic abuse at the weekend after blogging that Spain was insolvent.

When the principle of private sector bail-ins was established with the Greek sovereign debt write-off, the high command said this was the first and last occasion. Then came Cyprus, admittedly rather different, since this was a banking bail-in rather than a sovereign one, yet the underlying principle was the same. Again, they said Cyprus was unique. The sad reality is that it is not. If the euro survives, there will be other much bigger ones; more confiscation is inevitable. The dream has become a nightmare, yet still they want to keep it alive.